Pages

Sunday, December 9, 2012

Creating a Trading System III - Price Action Trading

Over the years I have tried nearly every system of trading. Nearly all of them have failed to generate consistent profit (although many did work for a few months). Some of this may be simply because the systems were not suited to my style of thinking but I believe most systems are biased towards a perma-bull market and will fail during any sharp bear move. And most such failures are spectacular.

One of the reasons for this is that newcomers are attracted to trading when they hear success stories from their friends and family. Such success stories, especially dramatic trades usually occur near the top of a bull market. Systems that have recently proven to be working in the past year or two are likely to be biased towards a bull market. This attracts newcomers right before an impending crash.

Systems that cannot work in both bull and bear markets are terrible choices for a trader. The best and largest moves occur in bear markets but bull markets last longer. Any system that cannot trade both is likely to be a poor performer unless you happen to start your trading career in a lucky decade.

After trying out indicators, buy and hold and all manner of fundamental trading, I finally settled on price action trading as a framework for my system. Price action fit well into my understanding of demand and supply and my observation that one cannot consistently predict at what price the market is likely to turn. Trends can be dramatic and sharp and last much longer than anyone can predict.

One of my early discoveries was that anything you may know about any system is probably incomplete. There will always be subtleties that you need to pay and learn over time. There will always be edge cases where a certain setup may not be valid and even after you have detailed experience trading a single setup, a good percentage of the time, the setup will simply fail to reach target before taking out your stop.

Another observation is that some setups are likely to give a large gain if they are successful. For example, the 1st pullback after a trend breakout early in the day is likely to give a large move lasting for at least an hour. Even if the setup here is weak, its often worth taking the risk of a small loss since the win will usually be very large and more than make up for a few losing trades.

There is simply no way around the fact that trading is a system of probabilities and you need to find and press your edge. When the winning probability of a setup is high, you can take the trade even when the expected gain is smaller.

Price action trading provides a general framework where I experiment, learn and build my trading system. Unlike a system that uses indicators which really has no framework but simply magic math that tries to convert a price movement into a binary buy/sell decision, a price action framework can keep you on the right side of the market, enable you to anticipate large moves or chop and act accordingly.

This general framework is a springboard from which you can refine your trading and market reading skills on your journey to be a profitable trader.